assuming the gap will eventually close,
and the pair will find harmony again.
OPPOSITES CAN ATTRACT
In a pairs trade, you take opposite positions in two different, yet similar, securities. You might take a bullish position on
one stock and a bearish position on the
other. The overall objective is to make
money on the relative price movements
between the pair.
For example, if the stock you bought rises in value, while the stock you sold short
stays the same or even drops in value, you
may end up with a profit. Sound simple?
It’s critical to remember that for pairs
trading to work best, it’s about relative
price moves, not actual stock prices.
Pairs trades can present potential
opportunities because the relative price
movements between two correlated stocks
may suddenly diverge. Above all, you
might expect the two stocks will eventually correlate again, causing the relative
price gap to revert back to “normal.”
SIZING THINGS UP
To capitalize on relative price moves between two stocks, a little math is needed so
you’re comparing apples to apples.
For instance, XYZ stock may be trading
at $50. But ZYX could be trading at $100.
Here, you simply divide the price of the
larger stock by that of the smaller stock
to approximate a ratio (2:1 in this example). Then, you’d trade two shares of the
lower-priced stock for every share of the
higher-priced stock. Because the percentage moves are similar, you would expect to
see $100 worth of long stock in one company paired against $100 of short stock in
the other company.
Here’s another angle. Let’s assume you
For starters, what’s a pairs trade? Imag-
ine ordering a peanut butter and jelly
sandwich for lunch (not swanky, I know).
If there’s too much peanut butter, your
tongue sticks to the roof of your mouth.
Too much jelly, and it’s falling into your
lap. Either way, you might send it back to
get fixed so it’s in line with expectations.
At the end of it all, your new sandwich
finds harmony and your mouth benefits.
This is pairs trading. Two stocks in
the same sector are generally expected
to trade in harmony, that
is, in a similar fashion. In
other words, they’re said
to correlate. Think Coke
and Pepsi, or Ford and GM.
Depending on the news
for each, day-to-day fluc-
tuations might look a little
different. But over time,
they’re likely going to trade in line with
When one stock starts to trade a little
out of whack and stray from the norm, the
two stocks are said to be “uncorrelated,”
creating a wider price gap between them.
Here’s where opportunity might emerge—
want to invest $2,000 in the trade. Splitting the difference, you can commit $1,000
to each position. It probably won’t be a
perfect 2:1 ratio, so simply divide $1,000
by the stock price. If XYZ is trading at $40
and ZYX is at $60, you’d pair 25 shares of
XYZ with 16 shares of ZYX.
BUYING AND SELLING
Let’s assume that stocks XYZ and ZYX are
in the same sector. For most of the past 60
days, you note they’ve traded in tandem.
But for the past week, you see that ZYX is
moving faster than XYZ. You may record
this as a widening difference in prices on
the chart. And it could be that XYZ typically trades slightly lower than ZYX. Assuming an eventual convergence, you may
decide to take action and buy XYZ while
selling ZYX in order to take advantage of
what looks like a temporary divergence.
You might profit from this trade if:
1—XYZ rises again more quickly than ZYX
2—ZYX falls faster than XYZ
3—XYZ rises and ZYX falls
In all three scenarios, the relative price
gap between the two stocks closes, and you
potentially profit from the trade. However,
should the opposite of any of these scenar-
ios occur, you could lose money instead.
You’ve probably guessed that you’re not
limited to pairing stock positions. In fact,
you can use a combination of ETFs,
futures, and options as well.
Stocks and ETFs. Often, you don’t have
to look any further than a stock that becomes uncorrelated to its relative sector.
Or you might buy or sell a stock and pair it
with a long or short correlating sector ETF.